You’ve no doubt heard about the harrowing ride investors took yesterday as the Dow took a 1,010 point nosedive and then recovered to close just 347 points down for the day. While there was no root cause of the dive, the riots in Greece following the Greek government’s approval of its portion of the European Union and International Monetary Fund bailout set the stage. While investors were already nervous, a “trading glitch” then sent investors running for the hills while high-frequency hedge funds, which use computers to trade at super high speed, appeared to pull back from the market as prices collapsed. These hedge funds have grown to account for a significant amount of trading volume, and their absence likely created a void into which prices fell. Some stocks fell briefly by 100% before recovering – prompting many to cry foul and blame the sell-off on a computer glitch.

While yesterday was no doubt a nerve wracking experience for traders on the floor, I felt even worse for the investors who had placed limit orders and implemented option strategies that were triggered by the sudden decline. And their misfortune is a lesson to us all in the dangers of placing automatic trading orders.
What are automatic trading orders?

Let’s face it – most of us are not day traders (although I wouldn’t mind the setup). We don’t spend all day watching the market with the phone in our hand ready to call our broker and yell, “Buy! Buy! Buy!” or “Sell! Sell! Sell!” Instead, technology has allowed us to set up “rules” that our broker (or rather his computer) can follow so that we get the best deal. The most common of these rules is the “limit order.”

A limit order is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. For example, if you want to buy the stock of a “hot” IPO that was initially offered at $9, but don’t want to end up paying more than $20 for the stock, you can place a limit order to buy the stock at any price up to $20. Your limit order may never be executed because the market price may quickly surpass your limit before your order can be filled, but by using a limit order you also protect yourself from buying the stock at too high a price.

During today’s rollercoaster ride, the sell limit orders of thousands of investors were triggered as stocks plummeted – just as they were supposed to. If an investor had placed a limit order with his broker to sell his P&G shares if the price fell to $50, then that sell order would have been triggered as the stock tumbled to its low of $39.97. The investor lost money on the sale, but at least he didn’t loose it all.

The problem was, the decline in prices was mostly artificial and not due to a true market-side sell-off. That means that within minutes, the stock bounced back up. The investor in P&G not only lost money on the initial sale triggered from his limit order, but her lost even more money as the stock rebounded back to close at $60.76. To make matters even worse, if the investor had held the stock for a long time and had a gain, he would be hit with a tax bill on the profits.

The limit orders, put there by investors to protect themselves from losing too much money too fast, ended up hurting them.

What do we learn? Do we abandon all electronic trading? Do we leave stock trading to the day traders? The short answer is no.The long answer involves you sitting down in front of your portfolio and assessing whether your limit orders are a) appropriate b) too concentrated or c) even needed. If you’re in the market for the long haul, chances are a limit order won’t be much help because the market always comes back eventually. Selling off your stock next week due to a limit order will seem pretty silly when it climbs back up in 3 years.

Yesterday’s events simply emphasize the underlying investing principles that I, as well as many other finance professionals believe in: moderation, diversity, long-term, and common sense.

One Response to “The Dangers of Automated Trading Orders”

Loren

18. May, 2010

The “limit’ orders you speak of in this scenario are ‘stop market’ orders, not limits. A limit order is to be filled at-or-better whereas a stop-market (stop-loss in this case) order becomes a market order once the designated stop price is traded, requiring a fill at any price no matter how much lower (or higher).